FMCG will perform in bad times

A rather intriguing hypothesis recently questioned the basis for growth in the Indian FMCG segment.

FMCG is seen everywhere as one of the safest defensive sectors – it’s classified as a non-cyclical perennial by many analysts.

This is because people continue to buy soaps and toothpaste even in a recession. So earnings are predictable.

In India, FMCG is also seen as a growth area, apart from being a defensive haven.

The logic is linked to poverty reduction and GDP growth.

As millions move up the income ladder from poverty, to the lower income group and from LIG to middle income group, and so on, they also aspire to using more in the way of personal care products.

There have been big gains in rural and semi-urban areas.

Despite the slowdown of the past three years, poverty reduction is still occurring at a substantial rate.

So, FMCG should continue growing. Plus, as logistics get better, distribution costs come down, allowing for superior margins and better penetration of undeserved markets.

This is a dynamic we have seen for the last 15 years.

The poor growth rates of this fiscal will generally be discounted as a worst case scenario occurring deep into a recession.

FMCG stocks continue to enjoy high PE ratios and they also continue to find high levels of support from FIIs and domestic institutions.

Everybody, including me, has cheerfully recommended these stocks for their combination of defensive strength and potential growth upside.

Now a researcher, Rahul Bhangadia, has written a piece in the personal finance magazine, Moneylife speculating that there’s a strong correlation between rising fiscal deficits and growth in FMCG sector.

Actually the hypothesis is broader, suggesting that consumption is driven by a higher deficit.

The data is spotty.

The published piece takes growth rates of a small group of FMCG companies and shows that the growth rates for FMCG stocks rose as the fiscal deficit started expanding in 2008-09.

As we know, attempts are being made in this fiscal year to curtail deficits -- that effort really started in the second half of the last fiscal.

As Plan expenditure has been slashed to cut the fisc, the growth rates of that basket of FMCG companies has reduced.

The author speculates that, perhaps growth in FMCG is connected to the fisc and if the government adopts more coherent deficit slashing measures, the growth rates in FMCG (and more broadly private consumption)

will continue to drop, even if GDP growth rebounds.

I don’t think there’s enough data cited in the study for any degree of rigour.

The hypothesis could be spectacularly wrong. But there is just a chance that it may be right. That could have interesting implications if true.

At some stage, this recession will end.

At that point of time, investors expect growth rates to rebound across many sectors.

FMCG stocks are expected to hold value through the recession, however long it lasts, and to participate in the rally when it ends. If FMCG growth rates fall at that stage, along with other consumption stocks, there will be holes in every portfolio.

As mentioned above, the evidence cited is not very strong (although there may be more data that hasn’t been cited).

Second, prior performance by FMCG stocks suggest growth rates have accelerated when GDP growth picked up.

There may be a connection with fiscal deficits but there is definitely a positive correlation with GDP growth.

The Indian pattern mirrors patterns seen in other developing nations.

Third, in practical terms, the Indian government is likely to remain unable to curb the fiscal deficit.

So whatever connection there is with a high Fisc, is likely to continue.

Nevertheless, the hypothesis set me thinking about the possibility of a potential re-rating of FMCG stocks.

It is true that these stocks are extremely high PE and the current growth rates don’t justify that. The “defensive premium” definitely leads to over-valuation.

The sector has always been highly valued. But if earnings growth rises across multiple sectors, there will be some rotation of money out of FMCG and into more risky assets.

So it is quite possible that the stocks in this sector will underperform during a big rally.

This doesn’t detract from defensive value because they will outperform during recessions.

The net capital gains from FMCG over a full boom-bust cycle are likely to be higher than the capital gains logged by most cyclical sectors.

However, there is a case for reducing weight in FMCGs once a full-scale rally is evident.

While FMCGs would probably continue to gain, other beaten-down stocks might gain more as the economy turned around.